Predicting the crisis: Medal winning analysts

If they were to hand out medals for predicting the global financial crisis, the Gold Medal for having predicted the crisis must go to Irving Fisher, who in 1933 developed the "Debt Deflation Theory of Great Depressions" - a piece which remains the best description of what happens to an economy that succumbs to excessive debt in the context of low inflation. We are now reliving the horror he warned us against.

Image: The Digerati Life

Silver goes to Hyman Minsky, for combining Fisher's insights with the vision of a cyclical economy he inherited from Schumpeter, and investor behaviour under uncertainty he acquired from Keynes, to develop the "Financial Instability Hypothesis". This theory explains how a period of economic tranquillity can lead to runaway expectations that induce a debt-financed speculative bubble like the one that we partied through from 1994 until 2007.

I'll award myself the Bronze, for having taken these two inspirations and developed mathematical models of financial instability in the early 1990s, which were the reason I expected that at some stage a serious financial denouement would arrive. My first academic paper on this topic, entitled "Finance and Economic Breakdown", was published in 1995.

I have a substantial number of colleagues in non-orthodox academic economics who, by their own developments of Minsky's analysis, also deserve awards for prescience. Prominent here are Wynne Godley, Marc Lavoie, Jan Kregel, Randy Wray, and Michael Hudson. Institutions like the Jerome Levy Institute and the Economics Department at the University of Missouri Kansas City have supported their work.

The most prominent relatively orthodox economist who foresaw this crisis was Robert Shiller, who originated the term Irrational Exuberance that was later attributed to Alan Greenspan. He has done an invaluable service by developing a long run price index for American housing.

Few academics have been as active in the public arena as they have been in scholarly research. Nouriel Roubini has made the outstanding public intellectual contribution here, with his RGE Monitor, which began operating in 2004-though it is a subscription only, for-profit site. Dean Baker of the Centre for Economic and Policy Research has also made substantive public and analytic contributions.

I began my public commentary on the debt crisis itself in December 2005, and have maintained a blog on this since mid-2006. Michael Hudson coined the phrase the FIRE Economy (Finance, Insurance and Real Estate) to describe the foundations of this speculative excess, and his website has significant material on the crisis.

Several notable stock market contrarians predicted a finance-induced catastrophe, none more so than Marc Sexton, who established the Fiendbear website in 1996, after starting to comment on the madness of the then very young Internet Bubble in 1995.

The most prominent contrarian commentator is Eric Janszen, who established the iTulip website in November 1998 to parody the then rampant ‘Internet Bubble' as a speculative mania. He shut the site down after the Dotcom Crash of 2000 only to be forced to start it again as the Subprime Catastrophe gained steam.

Not long after iTulip began, the financial market analyst Doug Noland started the Credit Bubble Bulletin, which was probably the most incisive academically-grounded commentary.

The academic economists who predicted this crisis were ignored because the mainstream of the economics profession follows what is known as neoclassical economics, which ignores debt and models the economy as if it is always in equilibrium. The contrarians were ignored because for so long, the way to make money was to "go with the herd". Today, conventional neoclassical economics is being starkly proven wrong by this very crisis, while contrarians are now the only ones making money.

The end of neo-liberalism? Implications of the crisis

The economic crisis that originated in US financial markets has now generated a global recession that seems certain to be the longest and deepest since that of the early 1970s. Economic events on this scale have significant ideological implications. The inflationary recession of the 1970s saw the failure of Keynesian economic management and the asso, and its replacement by monetary policies directed at stabilising inflation rates.

But the implications went much further this. Full employment, guaranteed by government policy was a crucial element in the social-democratic settlement that emerged after World War II. It ensured that governments could act independently of the views of business in general, and the financial sector in particular.

With the end of full employment and came a resurgence of free market ideas and policies, beginning with massive deregulation of the financial sector.  Will Hutton describes the process in detail. This was the beginning of the era of what has been variously described as Thatcherism, economic rationalism or neoliberalism.

The implications of the current crisis seem likely to be equally profound. While most political discussion is premised on the assumption that this is a temporary emergency, to be followed by a return to ‘normal' conditions as soon as possible, the changes that have already taken place make this assumption untenable.

Image: New Statesman

The disappearance, rescue or nationalisation of large parts of the banking sector will result in a fundamental change in the political landscape. As Joe Stiglitz observes, Wall Street has lost public trust and the financial system is now viewed as necessary but dangerous. The financial system that emerges from the crisis will be smaller, less powerful and more tightly regulated than the one that is now failing.

But the implications go much further. The whole intellectual structure supporting neoliberalism has been shown up as fundamentally flawed, as Madeline Bunting observes.

At the core of the problems is the efficient markets hypothesis (EMH), which states that the market price of a financial asset is the best possible estimate of its value. The crisis has left the hypothesis in tatters.

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century.

Does this mean the end of neoliberalism, and if so, what will replace it? It's too early to say for sure, and much will depend on the policies of the incoming Obama Administration and the success or failure with which they are attended. Still, it seems most unlikely that neoliberalism can survive in anything like its current form, and highly likely that its replacement will restore important elements of the mixed economy and the associated social democratic settlement.

Who to read on the GFC and economic philosophy:

Will Hutton: 'This terrifying moment is our one chance for a new world'

Joseph Stiglitz: 'The fruit of hypocrisy'

Madeleine Bunting: 'Faith. Belief. Trust. This economic orthodoxy was built on superstition'

John Quiggin: 'What does it all mean?' and 'The end of neoliberalism?' 

The financial crisis: The conclusion of a catalogue of errors

Even for the economically illiterate, it is increasingly impossible to avoid the news that the global economy is in the grips of a financial crisis. Whether it be observing the plunging graphs on the evening news, noticing the increasing number of ‘for sale' signs at the front of houses, appreciating the reduced cost of petrol at the bowser (which has been a knock-on effect of the global slow-down), reading the intellectual musings about the ideological longevity of capitalism in newspapers or simply spending your own slice of Kevin Rudd's $10 billion Christmas bonus, the cumulative effect has been inescapable: we are in the midst of a full-blown, ‘once-in-a-century' CRISIS. The seriousness of this situation has been routinely reinforced by the severity of the language used to describe it: ominous headlines predict economic devastation and ruin on a scale not seen since the Great Depression in the 1930s.

The two defining characteristics of this ‘crisis' have been the rapid speed at which the turmoil has manifested itself, and the unique causes that underpin it. The origins of economic downturns used to be at least somewhat comprehensible. But even a keen reader of the financial pages must have found their eyes glazing over when the conversation turned to collateralised debt obligations and asset-backed securities, alpha-seeking hedge funds and sub-prime mortgages.[1] In a paper written a year ago, Robert Hall, an economist at Stanford University, described this recession as a relatively ‘causeless' one.[2] Robert meant that interest rates never got very high and the Federal Reserve began to lower them before the contraction began. So if this meltdown is ‘causeless' in the traditional sense, how do we explain why it came about?

The roots of the current economic 'melt-down' can be located in the U.S. sub-prime mortgage crisis. The easy availability of credit to borrowers who had a high risk of not being able to repay their debt underpinned an unsustainable boom in (housing) asset prices. But this alone would not have been enough to prompt the crisis: the real problem was that the risks involved in these mortages were temporarily hidden as they were on-sold through complicated financial instruments. This phenomenon has been irreverently covered in an unconventional slide-show on the website businesspundit.com. 

The collapse of the housing market when those loans were unserviced had the knock-on effect of severely shaking consumer confidence. Michael Stuchberry has written on this phenomenon from the Australian perspective and experience. In turn, as major financial institutions began to topple, bank lending froze up because the banks were worried about not getting their money back. Alan Wood, the economics editor of The Australian reflected that ‘the financial excesses and overblown optimism of the easy money boom have turned into equally excessive risk aversion and irrational panic.'[4]

It is important to remember however, that this crisis was not a natural, inevitable catastrophe. The current depressed state of consumer and business sentiment can be attributed to specific failures on the part of policymakers, regulators and bankers. Firstly, governments and central banks failed to constrain an expansion of credit that drove an unsustainable boom in asset prices. Secondly, regulators failed to perceive the risks inherent in the financial system, and bankers exploited the latitude they were granted. Banks created marketable securities out of mortgage debt without a reliable assessment of the credit quality of that debt.

Who's worth reading on this?

Journalists, economists and commentators have, in the latter half of 2008, clamoured to define the causes of the current economic crisis. Niall Fegurson, writing in Vanity Fair, combines a broad grasp of history with economic nuance to offer an extensive explanation of the current situation. The Nobel Prize-winning economist Paul Krugman, writing in The Guardian, succinctly describes the scale of the housing bubble that initiated the crisis. Rather than viewing the crisis as a wholly unprecedented event, he argues that it is like every economic calamity experienced before coming ‘all at once'. Michael Stuchberry's response to Kevin Rudd's $10.4 billion stimulus package offers a succinct summary of the Australian experience of the global crisis.

In seeking to explain the crisis a number of other commentators have drawn parallels with the Wall St Crash of 1929 and the economic hardship that followed that event. The majority of analysts, however, have been quick to qualify such comparisons. The general confusion regarding the unfamiliar circumstances of this crisis means that the severity, length and extent of it estimated by pundits remains, largely, educated guesswork.    

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[1] http://www.timesonline.co.uk/tol/comment/columnists/gerard_baker/article2317283.ece  

[2] How much do we understand about the modern recession?" By Robert Hall, Brookings Papers on Economic Activity 2, 2007

[3] Allan Wood, The Australian, 9/10/08

What to do next? Policy directions after the financial crisis

Image: Australian Broadcasting Corporation

Nobel Prize winner Paul Krugman in an article states quite plainly that "Reform of the weaknesses... can wait a little while" and that the first priority is to "get credit flowing again and prop up spending".

Over the last 3 months, governments around the world have bailed out lending institutions, guaranteed deposits, and expanded the money supply.  The figures are astronomical.  Financial markets news service Bloomberg calculates that the total amount spent on the bailout in the USA is $7.76 trillion USD as at November 24^th. That amount could pay off half of all outstanding American residential mortgages, or provide $24,000 USD for every person living in the United States.

I have included a chart made in early November that compared the bailout at that stage in comparison to other large US government projects.  It clearly shows the extent of the first stage of policy response to the global financial crisis (GFC).

Image: Voltage Creative Blog

Hoping that its guarantees will not be called on, the Australian response has mirrored this shoring up of the financial system, albeit with less zeros. On the 12th October the government guaranteed $2 trillion in deposits and wholesale funding of financial institutions.  Under the Financial Claims Scheme, policyholders are now underwritten by the government in the case of the failure of a general insurer.

After the initial government bailouts of lenders in the UK and USA, Reserve banks around the world are now lowering short term interest rates, with RBA target cash rates now at 4.25% and the USA Federal Reserve targeting an incredibly low short term funds rate between zero and 0.25 %.  Beyond this, governments could also purchase long term treasuries to push down long term rates.

However there is a limit at which this provision of credit fails to improve an economy where borrowers just don't want to borrow.  Larry Elliot in the Guardian states that "There is talk of a classic Keynesian liquidity trap, when nominal interest rates fall close to zero and the authorities find it impossible to stimulate demand through lower borrowing costs."  British Economist Maynard Keynes famously described this problem with monetary policy as similar to 'pushing on a string'. 

Thus the next phase in government policy to assist the economy will have to involve a traditional 'Keynesian' expansion in government spending.  When an economy is contracting and has spare capacity, the government can boost the economy without causing inflation.

In his 1998 book, Restoring Japan's Economic Growth, Adam Posen found that Japan, during its 'lost decade' of stagnation during the 1990's, had success with fiscal policy when it was implemented.

The initial challenge is where to spend this money where it will enter the economy quickly and be spent to the best effect. Infrastructure has a higher multiplier than other forms of expenditure which means that for each dollar of spending results in a greater boost to economic activity.  Infrastructure spending can also address long term challenges such as climate change or water. 

Image: Moody's Economy.com

Earlier this month, faced with a government apparently reluctant to go into deficit and borrow from those in the economy who are too hesitant to invest, a group of Australian economists - Tony Cole, Saul Eslake, Allan Fels, Rod Glover, Nicholas Gruen, Ian Harper, Tony Harris, Mike Waller - wrote an open letter to the Prime Minister calling for aggressive stimulus of the economy, including spending on renewable energy infrastructure. 

While the Australian federal government may appear deficit 'shy', back in May they announced that they would provide legislative authority for an increase in future Commonwealth Government Securities issuance of up to $25 billion, which based on current estimates would enable the government to go into deficit.

Indeed the government has been spending rapidly, so far introducing $10.4 billion stimulus, the $6.2 Billion New Car plan, the $15.1 Billion in COAG spending on Health and Education infrastructure and training, and $2.5 Billion in new infrastructure spending announced on December 12. 

Infrastructure Australia, the government appointed advisory committee, has signed off on a priority list of projects to be funded from the $12.6 billion Building Australia Fund, so expect further announcements of government investment - possibly on urban transport infrastructure in the new year.  

The financial crisis – our great opportunity

Throughout the developed world, the financial crisis is prompting frantic calls for the restoration of economic stability as the number one priority for the immediate future. But as a procession of unsustainable organisations line up for bailouts, we are in danger of missing an opportunity to deal with a much bigger problem.

In 1972, the Club of Rome published ‘The Limits to Growth’, its report on the predicament of mankind, termed the ‘World Problematique’. This was the first attempt to explore the implications of exponential growth in population, consumption and pollution within a finite system, using a then-revolutionary world dynamics computing model developed at the Massachusetts Institute of Technology – requiring computers occupying hundreds of square metres of floor space, today available on a single laptop! The particular emphasis of the study was to examine the holistic interaction of humanity and biosphere, rather than looking at each issue in its separate silo. It also used scenarios to explore rather than predict, another novelty at that time.

The report was much maligned, both then and since, as being overly pessismistic and too academic. However, some of its scenarios are now turning out to be spot on, as a recent analysis by CSIRO scientist Graham Turner demonstrate.¹

At the end of WWII we had 2.5 billion people on this planet - a relatively empty world. Today we have 6.7 billion people, all aspiring to improved standards of living and increasing consumption. The result is already a full world in which we are exhausting the planet’s ability to accommodate the human species,² and yet population is forecast to grow to 9 billion by 2050.

Since 1972, considerations of the ‘problematique’ and the common good have taken a back seat to our unbridled individualistic dash for economic growth. We have proved incapable of accepting, so far, that the most important factor for our own survival is the preservation of a biosphere fit for human habitation. Given the current convergence of climate change, peak oil, food and water shortages, something clearly has to give, as conventional economic growth is untenable. Do we have the maturity to develop a genuinely sustainable alternative? Is the financial crisis the trigger to make it happen?

Image: Urban Sprout

Ideas for a Green New Deal

It is heartening that in response to these daunting challenges, new ideas and leadership are flowing freely. Lester Brown’s ‘Plan B – Mobilising to Save Civilisation’³ was one of the first. Jonathon Porritt’s ‘Capitalism as if the World Matters’,⁴ lays out a blueprint for reframing capitalism on a sustainable basis. Thomas Homer-Dixon’s ‘The Upside of Down – Catastrophe, Creativity and the Renewal of Civilisation'⁵, gives a fundamentally optimistic message of our potential to regroup and renew in the face of current challenges built around resilience concepts, provided we first accept the size of the problem. Worldwatch’s ‘Low Carbon Energy'⁶ outlines a framework for global low-carbon energy solutions. ‘Zero Carbon Britain'⁷ is a plan for simultaneously eliminating carbon emissions in Britain within 20 years and delivering energy security. ‘Green New Deal'⁸ proposes a fundamental reframing of the UK economy to meet the triple crunch of credit, climate and energy. ‘Beyond Zero Emissions’⁹ are developing similar concepts for Australia. To see how the ‘official future’ has changed, read the International Energy Agency’s ‘World Energy Outlook 2008’¹⁰, a comprehensive analysis of the energy and climate change challenge we face, calling for an ‘energy revolution’. The report is still too sanguine on oil supply, but represents a vast improvement on their previous unfounded optimism on the future of cheap energy. The Tallberg Foundation’s ‘Grasping the Climate Crisis'¹¹ challenges the widespread perception that nations are dealing effectively with climate change: “in fact almost nothing is happening yet at the global scale”. Their paper argues that policy should now be structured around risk management, the latest science (not just the IPCC), ethics and the common good rather than national self-interest. Finally, the Club of Rome is being rejuvenated to complete the task of catalysing solutions to the ‘problematique'.¹²

There is no shortage of ideas and the solutions are clear. The challenge is now for the community to demand change from the political and corporate world. The financial crisis provides our great opportunity to set the world on a new sustainable path, as many sacred cows, which have stood in the path of change, are being slaughtered by the day as the crisis unfolds. It is an opportunity we cannot afford to waste. If bail-out funds are to be provided, then they should come with very stringent conditions attached to ensure we move rapidly on to that new path and not just shore up an unsustainable system, to create an even bigger problem a few years hence.